The market is about to get a serious 'shock'

Markets are quiet, really quiet.

For 31 straight days, the S&P 500 has not moved 1% or more in either direction, and volatility in the market, as measured by the VIX index, has declined sharply since spiking following the UK’s vote to leave the European Union in late June.

The quiet summer is keeping investors complacent, according to Athanasios Vamvakidis, Adarsh Sinha and Yang Chen at Bank of America Merrill Lynch. The complacency, said the foreign exchange and rates strategists, is leaving investors seriously exposed.

Here’s their breakdown of the situation (emphasis added):

“The recent chase for yield has potentially reached an important inflection point. Selling vol to enhance yield is now at an extreme level, with net speculative VIX exposure at all time shorts. Furthermore, this reach for yield is apparent across FX, equity, and fixed-income markets. In our view, complacency combined with short vol exposure could set up the market for a highly volatile and correlated sell off on the next shock. Carry trades that look attractive due to severely depressed volatility levels could unwind on even a modest increase in volatility.”

Essentially, the strategists argue, in order to generate expected returns investors have increasingly reached to riskier assets. Thus, they are more exposed to losses if the market were to suddenly drop.

Exacerbating this problem is the recent trend on trades such as selling volatility. Put (extremely) simply, investors are selling “insurance” on movements in the VIX through a series of options. Thus, if there were a sudden uptick in the VIX, this “insurance” would be called in by the buyers, losing the sellers of the options money. (If you want to dive into the nitty gritty of this trade, here’s a deeper dive.)

According to Vamvakidis, Sinha, and Chen, the number of people selling volatility in this way has actually reached an all-time record.

“[Commodities Futures Trading Commission] positioning data reveals the shortest speculative positioning in VIX futures of all time, both confirming this trend and raising a red flag,” said the note.

Combine these two circumstances, said the strategists, and the adjustment to any coming shock in the market will be violent and painful. There are a number of upcoming events that could trigger this shock, said the note from BAML.

“While it is uncertain where the next shock will come from, we believe there are several possibilities,” wrote the strategists. “To name a few: a faster Fed hiking cycle than the market is expecting, US election uncertainty, and turmoil in Italian banks.”

No matter how it happens, said the BAML team, it is going to happen eventually. So, they suggest, “be fearful when others are greedy.”

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